As readers may recall, we had been skeptical (and critical) of the Public Private Investment Partnership from the outset. It was the third effort at a program that had failed twice under Hank Paulson, namely, to have banks get dud assets off their balance sheets by selling them to a sucker.

That’s why this program has never gotten airborne. It requires a bagholder.

The problem isn’t, contrary to PR designed to mislead the public, that the assets are hard to value. That holds only for an itty bitty percentage of the total. The real problem is that the banks are carrying them at above market values, and above any reasonable long term value too (their protests to the contrary). The problem is not the saleabilty of said assets, it’s that they don’t like the prices. Selling them at below the marked value leads to losses, which in turn would reduce their equity at a time when they have been told, in no uncertain terms, to get more.

So the only way the plan works is if someone overpays. The only party that might have reason to is Uncle Sam. The whole point of the “public private investment” part of this is to disquise the overpayment. So the plan is an opaque subsidy to the banks.

Why not do so in a more straightforward fashion? Well, if the Treasury did that, and got equity back, it starts to challenge the fiction that the public private partnership called banking in the US ought to be private. Team Obama has been schizophrenic about oversight, reacting to political hot buttons but not reining in bank risk taking, which is what it really should be worried about. Banksters have every incentive to swing for the fences to try to show good earnings and slip the government leash. And the Feds, contrary to expectations, are taking a tougher line on that front. I’m encouraged that the powers that be are not allowing the banks to base extrication from TARP based on 1Q earnings, which Meredith Whitney dismissed as “manufactured.” She was also of the view that core earnings were “negligible” and that banks had broken business models and no clear remedies. Apparently the authorities share at least some of her reservations.

Big banks were hoping billions of dollars in future revenue would help them fill the capital holes found in the government’s stress tests earlier this month. Now the Federal Reserve is limiting how much of that performance can be counted, according to people familiar with the situation.

The Fed’s decision is forcing Bank of America Corp. to come up with billions of dollars in capital from other sources, these people said. Other stress-tested banks also have revamped their capital-raising plans or might need to, including PNC Financial Services Group Inc. and Wells Fargo & Co.

The move by the Fed, which began notifying banks last week, has deepened tensions over the stress tests, which are intended to help steady the banking industry and shore up confidence in the financial system. The results were announced May 7, and banks face a June 8 deadline for government approval of their capital-raising plans.

Some banks had planned for financial performance in 2009 and 2010 to cover 20% or more of their capital shortfalls.

The Fed initially said the 10 banks ordered to raise a combined $74.6 billion would be allowed to essentially count $215.3 billion in revenue toward their estimated losses through the end of next year.

Since announcing the stress-test results, though, Fed officials have grown concerned that some banks are leaning too heavily on future revenue projections, according to people familiar with the matter. Under the new requirement, projected revenue can be used for no more than 5% of the additional equity being demanded from the 10 banks….

Bank of America, for example, said earlier this month that its financial performance would “significantly exceed” the government’s estimate, generating about $7 billion of the $33.9 billion the Charlotte, N.C., bank was told to raise. The bank said the $7 billion figure also would include security gains or other one-time actions.

Fed officials were surprised by the bank’s statements, believing they had been clear that such projections wouldn’t be allowed as part of the bank’s capital-raising plan, according to people with knowledge of the discussions. Since then, Bank of America has been told it won’t be allowed to count the entire projections toward its capital needs, which the bank viewed as a changing of the rules, these people said.

Hhhm. On this one, my instinct is to trust the Fed. I suspect someone at BofA at best interpreted an ambiguous remark in its favor. Not that the “he said, she said” matter, but the banks have been keen to portray the government as inconsistent, when they should be bloody grateful to not be nationalized and have had the temerity to negotiate the stress tests when they shoudl not be negotiable. So when the government accedes it is not being “inconsistent” (taxpayers would sure disagree with that one), only when it imposes requirements that the banks did not anticipate (but not anticipating them is a function of self-serving thinking, not necessarily a sign that the demand is unwarranted).

Back to the PPIP charade. We had heard early on that the bank loan side, aka the Legacy Loan Program, was going nowhere, so the semi-official word is no surprise. The excuse is that buyers fear a rule change (code for executive comp restrictions, amusing how that is the new hobbyhorse), but the bigger issue is that (again) the banks see no reason to participate. Translation: the program appears unlikely to produce bids for more than the carrying value of their assets.

A government program designed to rid banks of bad loans, part of a broader effort once viewed as central to tackling the financial crisis, is stalling and may soon be put on hold…

The Legacy Loans Program, being crafted by the Federal Deposit Insurance Corp., is part of the $1 trillion Public Private Investment Program the Obama administration announced in March as a way to encourage banks to sell securities and loans weighing on their balance sheets to willing investors.

But prospective buyers and sellers have expressed reluctance to the FDIC about participating for fear the program’s rules will change in a political atmosphere hostile to Wall Street. In addition, some banks that might have sold troubled loans into the program earlier in the year have become less eager as they regained a sense of stability.

PPIP was to be split between the FDIC program, which would buy whole loans, and one run by the Treasury Department focusing on securities. Treasury is expected to push ahead with its plan — the larger and more substantial of the two — and could begin purchases sometime this summer. But the size of that program could be smaller than initially envisioned, government officials say.

The scaling back of the FDIC program is potentially good and bad news for investors, indicating that the health of the financial system — while improving — remains fragile….

But, at the same time, administration officials say they believe the program to purchase toxic securities mightn’t be as integral to a recovery as it once seemed. Markets seem to have stabilized and banks appear more able to digest losses associated with the troubled securities.

Yves here. Given the carnage in the mortgage markets today (to be discussed in our next post), that optimism seems a tad premature. Back to the article:

People familiar with the matter say the FDIC is expected to delay a test run of the program that was set to take place next month. The program could be put on hold in the near future, people familiar with the matter said. FDIC officials had initially believed the program could buy as much as $500 billion in loans.

The program has also been controversial. Bank trade groups asked the FDIC to allow banks to use the program to purchase their own assets, which some felt could allow banks to game the process. Ms. Bair on Wednesday said that would never have been allowed to happen….

Another reason is concern about government scrutiny related to potential conflicts of interest. A recent law that allows the special inspector general of TARP to conduct audits of participants in the public/private partnerships spooked some investors, Ms. Bair said.

“Treasury will need to issue regulations, I think, to clarify those issues before we will have comfort by the participants,” she said.

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“Another trader who found himself underwater kept his positions from being repriced by simply not doing any trades. The prices of his inventory were marked to market only when there was a new trade, so whenever an inquiry came in from a customer, he would offer the bonds at far above the going price so that the customer would shop elsewhere and the trade would not go through. Without having any new trades, his positions remained on the books at cost despite a major market downturn.”

From Richard Bookstaber’s A Demon of Our Own Design (speaking about fraud in the late 80s). Imperfect, but interesting. Old tricks.

WSJ: The program has also been controversial. Bank trade groups asked the FDIC to allow banks to use the program to purchase their own assets, which some felt could allow banks to game the process. Ms. Bair on Wednesday said that would never have been allowed to happen….

———-

Very funny. Bair will let the banks purchase EACH OTHER's assets. As noted previously, there is precedent for the government allowing that kind of foolishness.

There is precedent. In 1980, the Federal Home Loan Board (FHLBB) issued Memorandum R-49, which allowed S&L's to do cross-purchases of "substantially identical" pools of mortgages purchase without recognizing losses for accounting purposes. The whole point of the FHLBB blessing these cross-purchases was to screw the IRS by letting the S&L's recognize tax losses by each S&L on its cross-sale, so for accounting purposes they pretend to sell each other pools of mortgages at book value to avoid having GAAP losses, but for tax purposes pretend to sell them at fair market value, and recognize tax losses equal to the spread between face and fair value.

Obviously, it made no sense whatsover to respect these transactions as cross-sales for tax purposes because the S&L's were in the same position economically before and afterward. But the Supreme Court blessed these deals anyway. Now, the banks basically want the Fed, FDIC, and Treasury to let them do asset swaps of substantially identical assets at inflated prices recognize tax losses, and not recognize accounting losses, but they want to turbocharge the transactions by getting non-recourse loans from the Fed/FDIC under the PPIP program for the inflated book price of the assets being swapped.

I was never a fan of PPIP. Yet, one can’t help but notice that the current rally started almost immediately after PPIP was announced. Has the period from mid-March through to now simply been a repeat of late-November through early January, with the next leg down to soon be upon us?

The three-headed pal-PPIPtation need three parties to make it work: a private buyer, a present holder, and a public guarantor. The FDIC as guarantor stood to take big losses; not popular in Congress. Any private buyer needs prices to be much, much lower than present quotes to make any money, unless this is a sham transaction. All present holders need sale prices to be so near to face you couldn’t slip a credit card in between bid and mark. —So the only way this could work would be sham transactions veiled from Congressional scrutiny.

The whole thing is what desperate frat boys come up with at term-end when their papers aren’t done and they’ve more finals to cram for then time remaining. Boys, that pig isn’t sleeping, it’s dead.

A good summary of the government’s interventions so far. I can’t help thinking that all of these ineffectual programs are meant to buy the banks time so that they can risk take and charge fees their way back to solvency. But the disparities between where they are and where they need to get to are just too great. They have been allowed to overprice their assets and devalue their debt and it is still not enough.

The key is to stick taxpayers with the losses but the mechanism to do so has not yet been found that won’t simultaneously expose the banks’ underlying bankruptcy.

“The excuse is that buyers fear a rule change (code for executive comp restrictions, amusing how that is the new hobbyhorse).”Disagree. While I’m not surprised that you take this view, it just doesn’t accord with what I’ve seen. I’ve spoken with numerous investment firms who were originally planning to participate in the PPIP/TALF programs, but who later put those plans on hold because of the risk that Congress will change the rules in the middle of the game if profit margins are too fat.

While some firms are obviously worried about the executive compensation restrictions, by far the biggest concern is that Congress will retroactively tax back their profits, or make some other unforeseen rule change a year or so down the road. H1B visa restrictions are also high up on the list of concerns.

As someone who used to work in finance, you should know that financial transactions are extremely complex, and virtually never hinge on hot-button political issues. I don’t know why you insist on interpreting everything through the uber-simplistic, “Wall Street is evil, taxpayers are pure of heart!” narrative.

If you have been following the Wall Street Journal on this one, and if you had read the full text of the article, as opposed to just the part I extracted, that is the issue they mentioned first. The convention in reporting is to organize issues in the order of importance in a story. The second argument, “fat profits might be clawed back” is s comp issue too, since the investors are money managers and in most cases privately held.

The Journal has repeatedly stressed the banks’ desire to repay the TARP, and the issue of comp is flagged as primary.

Now I have not interviewed investors, I as most bloggers are, am dependent on news reporting. But I suggest you reread the Journal on this. They have put the comp issue as primary, and I am assuming their reporting is accurate. You imply I am biased when, if the situation is as you suggest, the bias is in the source material, not my presentation.

Okay, I didn’t realize that the Journal had specifically mentioned executive compensation later in the article. But still, the Journal article lists 3 distinct concerns, the first of which happens to be executive compensation. That’s a long way from interpreting concerns about rule changes as simply “code for executive comp restrictions,” which is what you did.

Also, concerns about Congress retroactively taxing back profits are distinct from concerns about executive compensation restrictions. Profits aren’t the same as compensation. But you know that.

“They have put the comp issue as primary, and I am assuming their reporting is accurate.”

Do you honestly believe that? If there’s one thing I still agree with you on, it’s that press coverage of finance is, and always has been, abysmal. I think you and I both know that the press — even the Journal — hardly ever gets the story completely right. Professing deference to the Journal‘s journalistic protocols is about the last defence I expected from you.

Both the Journal and the Times, which does not have the same ideological axe to grind, even the FT pointed to executive comp as THE reason banks wanted to exit the TARP. Yes, there were other issues, but the beefing about executive comp vastly exceed the complaints on any other topic.

Why is it therefore so unreasonable to posit that the same issue is primary here? Look at the successful full court press they mounted on the proposal to tax upside fees as ordinary income. No tax expert will defend treating that as capital gains, and it didn’t seem likely they would win, but they did.

Given the background here, I see no reason to have questioned the Journal’s reporting, and I most assuredly do question it on other matters.

On the main point, I definitely agree with you. Executive comp is widely acknowledged as, and in my opinion almost certainly, the driving force here. There is a reason why a disproportionate amount of merger/reorganization negotiations focus on executive comp. It is a classic agency problem. The executives in theory should care about the health of the corporation, but in reality, they have proven that they care for little but their own compensation. This should hardly be controversial at this point.

As to the ordinary income/capital gains distinction, I must object. While I hope that the Congress one day changes the tax law to capture promotes as ordinary income, as partnership tax law is currently written, there is a not only a valid case for taxation of profits interests as capital gains, but an almost overwhelming one. The key is in your phrasing. You call them upside “fees.” What funds do is structure the upside as partnership interests rather than fees, and as partnership interests, the character of the income passes through from the partnership to the holder of the partnership interest. I don’t have time to fully explicate this idea, but it is not mere nomenclature; it represents a real tension in tax law regarding the taxation of future events and risk (though, as I said, there is ample cause for the Congress to decide that public policy is better served by taxing this kind of partnership income as ordinary income regardless of the underlying character of the gain…of course, we should just do away with the preferential capital gains tax rate to begin with…but that is a much larger topic).

“Both the Journal and the Times, which does not have the same ideological axe to grind, even the FT pointed to executive comp as THE reason banks wanted to exit the TARP. … Why is it therefore so unreasonable to posit that the same issue is primary here?”

Because we’re not talking about money center banks trying to exit the TARP; we’re talking about investment firms who (almost all) received no TARP money deciding whether to participate in the PPIP/TALF. They’re two distinct issues. Why would you conflate the two?

Also, the fact that the WSJ, NYT, and FT have all pointed to the primacy of the executive compensation restrictions doesn’t make it true. It’s just never that simple in the real world, and I think you know that. In my entire career, I’ve never worked on a deal where the true sticking point was the same as what the press claimed the sticking point was.

I have worked on deals as well, and on matters that were charged from a regulatory standpoint. On deals, generally the principals have plenty good reason not to be candid. In this case, they are using the press to make their case. If anything, they’d have good reason to underplay the executive comp issue, given how the public is hopping mad about it. The fact that senior executives have been making a big deal about it in the media says they do see it as a major issue.